Capital Reserve: This is a reserve which is created out of capital profits. Capital profits are not earned from the normal transactions of purchase and sale of goods or services in which the business deal. For example the profit earned by a printer by printing books is not a capital profit, it is a revenue profit. If the same printer sells his old printing machine for more than its book value, it is a capital profit. Such profits are not normally available for distribution as profit, because they are meant to either strengthen the business or write off capital losses. Examples of capital profits are:
a. Profit on sale of fixed assets and investments.
b. Issue of shares/debentures at premium.
c. Redemption of debentures at discount.
d. Revaluation of Assets and Reassessment of Liabilities. (No Cash is involved in this. For example land which appeared in the books at purchase price of Rs.100000 is revalued at Rs.500000. It involves a capital gain of Rs.400000 but no cash receipt is involved in it).
e. Profit on reissue of forfeited shares.
f. Profit in case of purchase of a business (if the difference between the value of assets and liabilities taken over is less than purchase consideration).
Let me explain you the meaning of following terms:
1. Forfeiture of shares: When a shareholder of a company is not able to pay some calls (instalments due on shares bought by him from the company), his shares are forfeited. This means the shares alloted in his name are cancelled and the money paid by him to the company for buying shares is also not returned to him. This is a capital profit for the company.
2. Redemption of Debentures: Debentures are the instruments issued by a company which recognise the loan taken by a company from general public or financial institutions. Redemption of debentures means returning the loan amount to the debentureholders on maturity of debentures (in simple language returning of loan).
3. Issue of Shares at Premium: A company can issue its shares at face value or at premium. For example a company may issue its share of face value of Rs.10 may issue for Rs.12. This means company is issuing its shares at Rs.2 more than its face value. This extra amount of Rs.2 is called premium. This is a capital profit. I would like to mention here that only a reputed company can issue its shares at premium.